Exchange Rates, Monetary Policies, and Macroeconomic Stability

Abstract

Three aggregated stochastic models are developed which incorporate the major features of small open economy with structural changes in different stages of economic development. For Model 1 and 2, both analytic and empirical studies are made. The optimal policy mix between exchange rate and monetary policies for achieving economic stability is analyzed when the economy faces unexpected shocks on demand and supply. Empirical studies of Korea concludes that it is not optimal to absorb the external shocks through full accommodation of exchange rates. Since Model 3 assumes rigid price and capital mobility, exchange rates are no longer policy variables and determined within the system. The optimal monetary policies under those conditions are analytically derived but empirical studies are postponed since capital flows are under strict control in Korea.